Is the Euro-Zone an Optimum Currency Area?

One of the most interesting developments in international finance took place with the introduction of the euro in 1999. At the time of its introduction, 11 European countries (among them, Germany, France, and Italy) gave up their national currencies to take part in a common currency area, known as the euro-zone. As of 2011, there were 17 European countries in the euro-zone.

Of course, the European common currency didn’t happen overnight. Starting in the 1950s, European countries went through various stages of economic and monetary integration.

The euro raises issues addressed by a theory known as the optimum currency area (OCA) theory. Consider a number of countries, and call them a region. If these countries experience similar macroeconomic shocks, and if there’s labor mobility between these countries, this region may be an OCA.

After adopting the common currency, countries of the region are expected to trade with each other more because of lower transaction costs and, consequently, enjoy price converge. However, as problems in some of the Euro-zone countries, such as Greece, Ireland, and Spain, revealed in the late 2000s, a common currency can also be problematic.

A common currency requires coordination in both monetary and fiscal policy. The European Central Bank (ECB) has worked to achieve monetary policy coordination, but it seems that there is no supranational authority in the European Union (EU) similar to the ECB to coordinate fiscal policies.

The lack of fiscal policy coordination has led to some of the euro-zone countries having high levels of debt. If financial markets view these countries’ debt as excessive, they may expect that highly-indebted Euro-zone countries may not be able to make payments on their debt, which means that these countries may default on their debt.

Therefore, higher levels of debt in some of the euro-zone countries may threaten the Euro’s credibility.